You may know your risks and the risks your counterparties pose. But how do your partners see you as a risk? That was one issue that came up in a discussion on counterparty risk evaluation frameworks at a first-half meeting of The NeuGroup’s Treasurers’ Group of Mega-Caps (tMega). Two members gave overviews of how they’re tweaking they’re frameworks, which helped boost confidence in the course of action that all are taking with regard to monitoring counterparty exposure.
One takeaway from the meeting was that CDS spreads are still valuable. Indeed, despite the thinning of single-name CDS trading, 5-year CDS spreads are still the number-one counterparty risk indicator for tMega members, according to the pre-meeting survey. The discussion at the meeting corroborated this result, with several members noting how CDS spreads, combined with other market indicators continue to serve as an early-warning signal. For example, the recent headlines surrounding Deutsche Bank were clearly preceded, by almost a month, with upticks in CDS spreads. Thus, the consensus was that regular monitoring of market-based credit information is still very much worthwhile.
Another suggestion coming from the meeting was to separate the notional vs. net, as well as VaR and MTM exposure numbers from the settlement amounts at risk. While not every member has two-way margin CSAs with their FI counterparties, those that do noted that having margin exchanges helps separate mark-to-market risk from settlement risk. This can be a good nuance to include in counterparty risk reporting: notional vs. net exposure limits. Another consideration is right of setoff. For example, one member noted how he wished he had had right of set-off stipulated for his line of credit with Lehman and outstanding derivatives, as this would have mitigated his exposure in 2008. Finally, both margin and right of setoff can be incorporated into a value-at-risk figure for each counterparty as a comparable to notional or mark-to-market risk.
With this in mind, it was also suggested to make sure policy guidelines are workable. One member noted a desire by the risk committee to have a percentage of tangible common equity as well as a 2-cent risk-to-EPS threshold for trading counterparties. However, his current exposure to several trading counterparties is way over that now, and it will be impossible to do trading business under such limits. Hence he had to push back on such a limit.
Finally, have a word with your cousins on the banking side; i.e., reach out to the treasurers of financial counterparties. To get further context to the counterparty credit risk signals, one member noted regularly reaching out to the treasurer of his key trading counterparties, which this member said turned out be insightful and gave “an extra level of comfort” to complement the counterparty risk indicators, the treasurer noted.
The unprecedented conditions in financial markets and the changing nature of how credit risk is being measured, especially at heavily regulated, globally significant financial institutions, are cause for treasurers to review and up the sophistication of their counterparty risk monitoring, mitigation and reporting frameworks. None of this should take place without peer dialogue with the treasurers of those counterparties, and we should expect that more such dialogue will be taking place on a regular basis. In the process, both sides can exchange information to improve each other’s credit view. For treasurers on the non-FI side, this dialogue should also underscore the importance of collateral and internal risk models to credit pricing going forward.